Ethics & Public Policy Center

Don’t Kill the Cadillac Tax (Yet)

Some Republicans are eyeing repeal of Obamacare’s “Cadillac tax” as part of a larger plan to roll back some of the law’s most unpopular and unworkable provisions. It is certainly a good idea to move legislation this year that begins to push back against Obamacare’s many excesses. But the Cadillac tax is the last provision Republicans should be targeting for repeal right now, and they certainly shouldn’t repeal it without replacing it with something more sensible.

This tax became part of Obamacare through a combination of cynical politics and practical necessity.

The story begins during the 2008 campaign, with Barack Obama’s shameless attacks on John McCain’s health plan. Senator McCain proposed replacing the existing tax preference for employer-sponsored insurance — which excludes employer-paid premiums from workers’ taxable compensation — with a universal and refundable tax credit that all U.S. households would get regardless of their employment status or whether they owed income taxes.

McCain’s refundable tax credit — $2,500 for individuals and $5,000 for families — would have been a very progressive change, as the value of the credit would have far exceeded the value of the exclusion for most lower- and middle-income households. Moreover, health economists from all points on the political spectrum have long identified the existing tax exclusion as a major source of upward pressure on health-care costs. There is no limit on the exclusion, so employers and their employees have a strong incentive to move more and more compensation into health benefits at the expense of cash compensation. This is one reason for flat wages in recent years.

Because it’s limited to employer-sponsored insurance, the tax break is also unfair to the millions of Americans who are not working or whose employers do not provide a plan. Before Obamacare, people in these circumstances got no federal tax break that was comparable.

After the election and inauguration, as the new administration began assembling their plan for health care, President Obama changed his tune. He had promised that his plan would improve the federal budget outlook, and that it would include effective measures to control rising costs. His advisers told him that, to meet these goals, it was essential to do something about the open-ended tax break for employer-paid insurance premiums, despite what he had said about the subject during the campaign. The president agreed, but he wanted to find a way to change his position without admitting he had done so.

And so the administration came up with the Cadillac tax. The president and his team claim the tax will have no effect on workers or individual taxpayers, because it is structured as an excise tax on employers who sponsor expensive plans. That is false. Economists at the Congressional Budget Office (CBO) and elsewhere believe the Cadillac tax will have pretty much the same effect on employer plans that a straight limitation on the tax exclusion would. Employers will respond to the prospect of paying the tax by adjusting what they offer to workers to keep premiums below the relevant thresholds. That means they will raise deductibles, trim benefits, and narrow the networks of physicians and hospitals participating in their plans. In other words, employers are going to offer less valuable health benefits to their employees.

It is not an exaggeration to say that the president’s barrage of ads against Senator McCain on this issue helped him win the 2008 election. He then turned around, in a matter of months, and did exactly what he accused Senator McCain of planning to do, which is to “tax health benefits for the first time in history.”

The news isn’t all bad for workers, though. CBO and others say that, as employers cut back on what they provide in health benefits, they will provide roughly commensurate increases in salaries and wages. But since salaries and wages are taxable, while the health insurance they will replace is not, CBO believes that the Cadillac tax will increase federal revenue far beyond the small amount collected through the tax itself, which most employers will avoid. CBO’s latest estimates indicate that the Cadillac tax will generate $87 billion in additional federal revenue between 2018 and 2025.

Although the Cadillac tax will have much the same effect as a direct limitation on the tax preference for employer-paid premiums, it is poorly designed. While most employers will avoid the tax, there are always exceptions to the rule. Some employers will in fact pay the 40 percent excise tax, and when they do, they are likely to pass on the added tax liability to their workers through reduced wages. These wage reductions will fall heaviest, in proportional terms, on the lowest-paid employees.

If Congress had instead placed an upper limit on the tax preference for employer-paid premiums, premiums paid by firms above the limit would simply count as taxable income to the workers. That’s a far more progressive way to address the problem, because higher-wage workers are in higher tax brackets and thus pay higher marginal tax rates on additional taxable income than do their lower-paid fellow employees.

The Cadillac tax is also designed to hit more and more households over time. The thresholds are indexed each year, but to the Consumer Price Index, not to health-cost inflation or even growth in the national economy. (In 2019, the thresholds will go up by the CPI plus one percentage point; after that, they go up only with the CPI.) Very soon, this tax — sold to the public as hitting only the most expensive health plans — will be affecting health benefits for a large share of the work force.

So there’s a lot not to like about the Cadillac tax. But that doesn’t mean the GOP should be targeting it for repeal this year. Again: The Cadillac tax is going to operate much like an upper limit on the tax preference for employer-paid health care, which is a good thing. The GOP would be crazy to repeal it without also putting in its place a more rational and straightforward tax-limitation provision.

In fact, repealing the Cadillac tax would play right into the Democrats’ hands. The Cadillac tax is among the least popular provisions in the law because both labor unions and businesses realize it will work as intended. If the GOP helps to kill this tax, the rest of the law will become more entrenched, and there will be very little reason for unions or employers to ever support other changes to Obamacare.

The GOP has an opportunity this fall to move legislation that makes progress on rolling back Obamacare. Republican members of the House and Senate should target a number of high-profile provisions that the public does not support, including the Independent Payment Advisory Board and the employer mandate. But they should not target the Cadillac tax unless they plan to replace it with a better approach. That seems unlikely for political reasons, so the best course for the GOP at this point is to leave the Cadillac tax in place and deal with it, along with everything else in Obamacare, in a larger replacement plan that could be taken up when a new president assumes office in 2017.